white house burning - simon johnson

As the party of small government, the Democratic-Republicansbelieved that higher federal tax revenues constituted a threat to individuals’and states’ rights.5 Perhaps more importantly, t

Copyright © 2012 by Simon Johnson and James Kwak All rights reserved Published in the United States by Pantheon Books, a division of Random House, Inc., New York, and in Canada by Random

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Library of Congress Cataloging-in-Publication Data

Johnson, Simon, [date]

White House burning : the founding Fathers, our national debt, and why it matters to you / Simon Johnson, James Kwak.

v3.1

To Sylvia, Willow, Boo, Mary, Celia, and Lucie

3 Deficits Don’t Matter

4 What Does the Federal Government Do?

5 Why Worry

6 Arguing First Principles

7 Where Do We Go from Here?

About the Authors

In Praise of White House Burning

Other Books by This Author

Nothing is more important in the face of a war than cutting taxes

—House majority leader Tom DeLay, 20031

On June 1, 1812, President James Madison sent a letter to Congress asking it

to consider a declaration of war against Great Britain The Republican majority in Congress was happy to oblige For the original WarHawks, only military force could avenge repeated British infringements onAmerican sovereignty—“the spectacle of injuries and indignities which havebeen heaped on our country,” in Madison’s words.2 The insults to the UnitedStates ranged from seizing American ships on the high seas and impressingtheir sailors into the Royal Navy to supporting Native American attacks alongthe Western frontier Attempts to apply economic pressure had back red, anddiplomacy appeared to be leading nowhere; as Madison said, “Ourmoderation and conciliation have had no other e ect than to encourageperseverance and to enlarge pretensions.”3

Democratic-With war approaching, it fell to Treasury Secretary Albert Gallatin to payfor it Gallatin hoped to nance the war with borrowed money, but hewanted to raise taxes enough to cover the interest on new debt.4 Withouthigher taxes, he worried that bond investors would not be willing to lendlarge amounts of money to a young country ghting with a Europeansuperpower But the War Hawks were ideologically and politically opposed totaxes—particularly the excise (internal trade) taxes that Gallatin wanted toimpose As the party of small government, the Democratic-Republicansbelieved that higher federal tax revenues constituted a threat to individuals’and states’ rights.5 Perhaps more importantly, they feared that raising taxes toght a war could hurt them at the ballot box.6 Congress did increase sometari s (taxes on external trade) in the run‑up to war, but failed to approvethe internal taxes that Gallatin had pressed for, instead authorizing theTreasury Department to borrow money But there were not enough investorswilling to lend the amount needed, even before war began, forcing thegovernment to print paper money.7 On June 18, 1812, the United Statesdeclared war against Great Britain Less than a month later, Congress

Hampered by Congress’s reluctance to raise taxes, the Treasury Departmentstruggled to pay for soldiers in the eld and ships at sea In 1813, with thegovernment only weeks away from running out of money, Gallatin wasforced to rely on Philadelphia banker Stephen Girard to underwrite a massiveloan—because, at that point, Girard’s credit was better than thegovernment’s.8 The United States military could win individual victories, butwas unable to achieve any of its major objectives, su ering repeated defeats

on the border with Canada, even with Great Britain distracted by the muchlarger war against Napoleon in Europe Congress nally agreed to imposeexcise taxes in 1813,9 but it was too late to build a world-class military After

a decade of tight budgets, the U.S Navy began the war with all of seventeenships The Royal Navy commanded over one thousand ships; even with many

of them committed elsewhere, it was still able to blockade the Easternshoreline and raid the coast almost at will.10 Chesapeake Bay, the broadwaterway leading to both Washington and Baltimore, was defended by acollection of barges and gunboats that were outclassed by the British navyand soon trapped in the Patuxent River.11 The approach to Washington alongthe Potomac River was guarded by Fort Warburton, completed in 1809, aboutten miles downstream from the capital.12 But when Pierre Charles L’Enfant,the architect and city planner who had designed the city of Washington,inspected the fort, he found it severely de cient and recommended aredesign, more heavy guns, and construction of a second fort nearby Thesecretary of the navy added some more guns, but there was no money forfurther improvements.13

In August 1814, British forces sailed into the Patuxent, an inlet ofChesapeake Bay that points toward Washington They cornered theovermatched defensive otilla, forcing the Americans to scuttle their ships,and landed ground forces in Benedict, Maryland, less than forty miles fromthe U.S capital The soldiers marched overland from Benedict, defeated anAmerican militia at the Battle of Bladensburg, and eventually reachedWashington, where they encountered little resistance On the night of August

24, they burned the Capitol, the Treasury Building, and the White Housea —after eating the dinner that had been set for that evening Another Britishsquadron sailed up the Potomac and bombarded Fort Warburton, whosedefenders quickly abandoned their positions From there, they continuedupriver to capture the city of Alexandria, which was commercially moreimportant than Washington at the time, seizing twenty-one merchant ships

and their cargo.14

For the Americans, the burning of the White House was the low point ofthe war, a moment of national humiliation that remains an iconic image inU.S history Despite the symbolism, it was not a decisive turning point in thecon ict; the two sides negotiated a peace later that year after deciding thewar was no longer worth ghting.15 But the vulnerability of America’s capitalhighlighted the danger of going to war against one of the world’ssuperpowers unprepared As Admiral George Cockburn supervised thedestruction of o cial Washington, someone called out to him, “If GeneralWashington had been alive, you would not have gotten into this city soeasily.” “No,” Cockburn replied “If George Washington had been president weshould never have thought of coming here.”16 But Washington, who had beenforced to ght the Revolutionary War with an under-equipped, underpaidarmy, knew as well as anyone that any military was only as strong as thetreasury that backed it What the British had, more than anything else, wasmoney—money to out t and equip hundreds of ships and to ghtsimultaneous land wars in Europe and North America By contrast, without astable source of tax revenue, the United States struggled to attract lenderswilling to bet on the country’s unproven armed forces Right up until the end

of the war, military operations were hampered by failures to pay troops andcontractors.17

This deep scal crisis was the product of one of the most bitter, divisivepolitical struggles in American history Beginning in 1790, Treasury SecretaryAlexander Hamilton pushed through a controversial series of scal policiesthat included restructuring the national debt, federal government assumption

of state debts, a national bank, and excise taxes Opposition to Hamilton’spolicies led Thomas Je erson and James Madison to found the Democratic-Republican Party (often known simply as the Republican Party), which faced

o against Hamilton’s Federalists.b The small-government, antitaxRepublicans swept the elections of 1800, with Je erson defeating Federalistincumbent president John Adams, and proceeded to reverse some ofHamilton’s policies, repealing the excise taxes in 1802 To pay for these taxcuts, the Republicans cut defense spending, which was one reason for themilitary’s unpreparedness in 1812.18 The elimination of internal taxes alsomade government revenues dependent on tari s, which were gutted rst by

an embargo against Great Britain and then by war It was this battle overtaxes and spending that led to the country’s fiscal weakness in 1812

Ironically, the Republicans, who voted for war but not for the taxes to pay

for it, were the political victors of the War of 1812 The Federalists’opposition to the war—which, in some cases, extended to attempts toundermine the Treasury Department’s e orts to raise money—made the partyappear unpatriotic, and it never again gained power on the national level.19

In a sense, however, the war also vindicated the principles laid out byHamilton two decades before Both Federalists and Republicans had alwaysbeen “ scally responsible” in the shallow sense that they believed the countryshould make required payments on its debts But there is a deeper meaning ofscal responsibility: the recognition that if you want something, you have topay for it, either now or in the future If a government cannot demonstratethat type of scal responsibility—through the willingness and capacity tolevy and collect taxes when necessary—it will have trouble borrowing money

in a time of crisis This was missing in the Congress of 1812 AsRepresentative John Randolph (an antiwar Republican) said sarcastically tohis pro-war colleagues, “Go to war without money, without a military,without a navy!”20 By 1813 and 1814, however, it was Republican majorities

in Congress that voted to reinstate and then raise the internal taxes originallyimposed by the hated Federalists.21 Some things, everyone agreed, were worthpaying for

Fast forward to 2011 Once again, Washington is embroiled in a bitterpartisan ght over taxes, spending, and debt This time, unlike two centuriesbefore, it is not primarily about war, although troops are still on the ground

in the Middle East The United States is the world’s only true superpower,with the largest military and the largest economy on the planet, and itsnational survival is not in question Nor does the Treasury have any troubleborrowing money The dollar is the backstop currency of the global economy,and Treasury bonds are used in nancial markets as the very de nition of asafe asset.c Although the national debt is more than $10 trillion,d interest onthat debt is barely $200 billion per year—less than 10 percent of the federalgovernment’s tax revenues.22 Investors around the world, seeking safety fromeconomic problems elsewhere, are hungry to lend money to the United States:interest rates on Treasury bonds are at their lowest level in more than half acentury.23

And yet, on August 2, 2011, political squabbling brought the United Stateswithin a few days of defaulting on its debts.24 Because of the debt ceiling—alegal limit on the total national debt—the Treasury Department could no

longer borrow new money and would soon run out of cash to pay all of itsbills.25 Republicans in Congress demanded that any increase in the debtceiling be accompanied by equivalent, dollar-for-dollar reductions inspending;26 Democrats, led by President Barack Obama, insisted either thatthe debt ceiling be increased without conditions or that any deal to reducethe de cit also include increased tax revenues (Both sides declined tomention the fact that they had just months before collaborated on a major

tax cut that increased the national debt by almost $860 billion.)27 A minority

of in uential Republicans even argued that defaulting on the nation’s debtswould be a good thing, and they were seemingly backed by a plurality of thepublic, which opposed raising the debt ceiling in the abstract.28 There the twoparties stood until, on August 2, the Senate passed and the president signed acomplicated compromise hammered out just two nights before.29 Theagreement cut spending by $900 billion over the next ten years and called on

a bipartisan congressional committee to come up with a plan to reduce

de cits by an additional $1.2 trillion over the same period Three monthslater, just before its deadline, the so-called supercommittee gave up, unable

to agree on anything

This latest battle over taxes and spending was provoked by record federalgovernment budget de cits, which in 2009 and 2010 exceeded $1 trillion forthe rst and second times in history These de cits were not the result of war,although a decade of ghting in Afghanistan and Iraq certainly contributed

to them They were primarily due to the 2007–2009 nancial crisis, whichtriggered a severe recession, reducing tax revenues and increasing governmentspending under existing programs The second most important cause of those

de cits was major tax cuts in 2001 and 2003 that—unlike the 1802 tax cut—were not o set by spending reductions.30 But the real debate is over futurespending

In 1812, some Republicans like Randolph opposed the war because they didnot want higher spending or higher taxes; Treasury Secretary Gallatin, underorders from President Madison to prepare for war, wanted higher taxes tohelp pay for the higher spending,31 but the majority of Republicans wantedwar without the necessary tax increases Today, the central debate is overincreasing federal government spending on retirement, disability, and healthcare programs such as Social Security, Medicare, and Medicaid, whichthreatens to outstrip growth in tax revenues One possibility, favored by mostRepublicans, is to scale back those programs to avoid the need for highertaxes Another possibility is to maintain those spending commitments while

raising taxes to pay for them A compromise position—some spendingreductions and some tax increases—is also conceivable But our highlypolarized political system is on the course set by the 1812 Congress: higherspending without higher taxes This inability to make any scally responsiblechoice is how a dysfunctional political system could cause a true scal crisis

—in one of the richest, most powerful nations in the history of the world

In the War of 1812, Congress quickly learned that ghting a war withoutthe money to pay for it was a dangerous proposition, leading to the taxincreases of 1813 and 1814 This time, there may be no such wake‑up call.The primary forces behind increasing government spending—an agingpopulation and rising health care costs—move slowly but surely, eroding thegovernment’s scal foundation over decades This gives politicians ampletime to rail against de cits while failing to do anything about them,con dent that the true crisis will not arrive on their watch The specter ofnational de cits has been a xture of American politics for most of the threedecades since Ronald Reagan won the presidency by promising higher defense

spending, lower taxes, and lower de cits.32 Reagan then oversaw what were,

at the time, the largest peacetime de cits in history, caused largely by a huge

1981 tax cut,33 yet su ered no political consequences as a result The lesson,according to George W Bush’s vice president, Dick Cheney, was that “Reaganproved de cits don’t matter.”34 In 2005, Bush attempted to use SocialSecurity’s long-term de cit to gain support for reforming the popularretirement program The president traveled to a Bureau of Public Debt o ce

in West Virginia and dramatically warned, “The retirement security for futuregenerations is sitting in a ling cabinet”; according to his eyewitness account,

he said, “There is no trust fund Just i.o.u.’s that I saw rsthand.”35 Yet hisproposal to reform Social Security—diverting some contributions into

individual accounts, similar to 401(k) accounts—would have added close to a

trillion dollars to the national debt over the next decade.36 Over the pastthirty years, in ated rhetoric about the national debt has mainly served as arhetorical tool that politicians use to argue for unrelated policy objectives,which as often as not increase the debt

But we should not be too quick to place all the blame on the political class.Politicians, after all, are elected by ordinary people And ordinary people, atleast as measured by opinion polls, are also deeply divided—withinthemselves In early 2011, 64 percent of Americans worried a great dealabout “federal spending and the budget de cit” (second only to the

“economy”).37 In one survey, 95 percent of respondents supported reducing

the de cit by cutting government spending (on its own or in conjunctionwith tax increases) At the same time, however, 78 percent opposed cuts inMedicare spending, 69 percent opposed cuts in Medicaid spending, and 56percent opposed cuts in military spending.38

It is no surprise that people can be illogical After all, it’s not fair to expectmost people to know what proportion of federal spending goes to popularprograms like Social Security (20 percent) and Medicare (13 percent), or howmuch of the de cit is due to their favorite tax breaks like the home mortgageinterest deduction ($94 billion) or the deferral of taxes on retirementaccounts ($142 billion).39 But the problem goes deeper: many people have noidea what the federal government does According to a 2008 survey, 44percent of people who receive Social Security retirement bene ts say thatthey “have not used a government social program.” The same goes for 40percent of Medicare recipients and 43 percent of people who have collectedunemployment insurance bene ts.40 Of the people who denied using anygovernment social programs, 94 percent had bene ted from at least one.41 In

2009, when an attendee at a town hall meeting told Republicanrepresentative Robert Inglis of South Carolina to “keep your governmenthands off my Medicare,”42 many commentators laughed But the joke is on all

of us People who do not realize that they bene t from the government’slargest social programs unsurprisingly think that the government is too big,their taxes should be lower, spending should be lower, and yet their favoriteprograms should not be touched

Politicians behave accordingly So, during the health care debate of 2009,Republicans positioned themselves as defenders of Medicare spending,

opposing cuts proposed by the Obama administration (remember, people like

Medicare) On December 6, Senate majority leader Mitch McConnell ofKentucky issued a press release entitled “Cutting Medicare Is Not WhatAmericans Want.” But the next day, responding to a Democratic proposal toallow people of ages fty- ve to sixty-four to buy into Medicare, McConnellplayed the de cit card with another press release, “Expanding Medicare ‘APlan for Financial Ruin.’”43 While it is possible to reconcile those twopositions, the politics are quite simple: oppose any e ort to expand populargovernment programs on the grounds that they are scally unsustainablewhile simultaneously attacking any e ort to make them sustainable bycalling it a cut in bene ts (or an increase in taxes) In 2011, when HouseRepublicans proposed to convert Medicare from a health insurance plan into

a program to help people buy health insurance from private insurers,

Democrats attacked them for cutting Medicare As economist Brad DeLongsaid, “the political lesson of the past two years is now that you win elections

by denouncing the other party’s plans to control Medicare spending in thelong run . . . sitting back, and waiting for the voters to reward you.”44 This isnot an encouraging picture

As a nation, however, we will make a choice, one way or another Thegovernment budget de cit—the di erence between spending and revenues in

a single year—will decline in the next few years as the economy eventuallyrecovers, but will then begin to climb again Each year that the governmentruns a de cit, it must borrow money (by selling bonds) to make up the

di erence, and that borrowing adds to the national debt.45 In other words,

the de cit is a flow, like the water pouring from a faucet into a bathtub, that

is measured over a period of time (typically a year); the national debt is a

stock, like the water in the bathtub, that is measured at a speci c moment

(typically at the end of the year).46 De cits uctuate up and down, primarilybecause of changes in economic conditions, but in the long run it is thenational debt that matters; the larger the debt, the more money must be spent

on interest payments each year.47 And since the economy as a wholegenerates the resources available to pay o the debt, what really matters isthe debt as a proportion of the economy, most commonly measured in terms

of gross domestic product (GDP)—the total value of all the goods andservices produced in the country in a given year

Figure I-1: National Debt as a percentage of GDP, 1790–2010

At the end of 2010, the national debt was $9 trillion ($29,000 per person),

or 62 percent of GDP ($14.5 trillion)—the highest level ever recorded exceptduring World War II (see Figure I-1) That gure, which re ects the amountowed by the federal government to the public, does not include the

“unfunded obligations” of major programs such as Social Security andMedicare—the gap between their future revenues and spending commitments

in the long term While economic growth over the next few years willprobably make the debt shrink modestly as a share of GDP, it should resumeits upward trend around 2020 as government spending grows faster than taxrevenues, which is likely under current policies.48 Social Security spendingwill grow because of pure demographics—the retirement of the baby boomcoupled with increasing life expectancies—which means the ratio of workers

to retirees will go down Medicare spending will grow even faster because, ontop of demographic trends, health care costs are growing much faster thanoverall in ation.49 As the debt increases, annual interest payments will grow

as well, consuming an increasing proportion of all tax revenues andconstraining the government’s ability to invest in other priorities rangingfrom national defense to poverty relief At some point, if the national debtgrows faster than the economy for long enough, bond investors could losetheir appetite for Treasury bonds, making it impossible for the government toborrow money at any price—as almost happened in 1813

The most immediate problem facing our nation is the high level ofunemployment that persists years after the peak of the financial crisis, leavingthe economy operating signi cantly below capacity But our national debt,and the spending and tax policies that underlie its growth, will be a majorchallenge for at least the rest of the decade, as we gure out how to adaptour government and our society to ongoing demographic trends and risinghealth care costs We could end up in a world with low taxes and limitedgovernment, where people are largely left to make do as they can, or in aworld with high taxes and expansive government services, where people areprotected from the risks of unemployment, disability, old age, and poorhealth The choices we make during this transition will help determine thenature of American society for generations to come

Today’s trillion-dollar de cits are a direct result of the recent nancial

crisis Our previous book, 13 Bankers, told the story of how an innovative,

predatory, and powerful nancial sector convinced o cials in Washington to

look the other way as it nearly wrecked the global economy That calamityconvinced many people across the political spectrum that our nancialsystem was broken—but the subsequent campaign for reform ran aground onthe rocks of a monumental lobbying campaign launched by the banks andtheir allies.50

By blowing an enormous hole in the federal budget, the nancial crisis haspushed de cits and the national debt to the top of the agenda in Washington.The politics of taxes, spending, and de cits, however, appear even more toxicthan the politics of nancial reform—in part because they raise fundamentalquestions about the role of government in society On one side, people whohave long opposed government action—including oversight of the nancialsystem—now see looming de cits as proof that government spending must beslashed On the other side, the catastrophic failure of nancial deregulation,high levels of inequality, and the sorry state of the economy argue for greatergovernment intervention In addition, any proposal that would actuallyreduce de cits is sure to face bitter opposition from whatever interest groupwould pay for it Listening to the rhetoric in Washington and in the media, itseems as if all sides have dug their defensive forti cations and are willing toght a long war of attrition to protect their positions, be they low taxes,robust social programs, or prized tax breaks

This book is our e ort to explain how our country got into this situationand what is at stake in these debates The rst three chapters tell the story ofthe national debt and the economic and political forces that have shaped itover time The next two chapters describe the factors behind today’s de cits,how they are likely to evolve in the future, and why they matter to ordinarypeople In the nal two chapters, we o er our own thoughts on how toreduce the long-term national debt while preserving the most importantservices that the federal government provides to all Americans today

We do not expect all or even most readers to agree with our proposals But

if the American people understand where our national debt came from, thestakes involved, and the tradeo s involved in reducing the debt, we will beable to choose the future that we want for our government and our society.Until then, our politicians will continue to stagger from one election to thenext peddling meaningless and contradictory slogans, full of sound and fury,signifying nothing There is no need to convince you of that: the evidence isall around you

a The building was not o cially known as the White House until 1901 Although the 1814 re severely damaged the

interior of the building, its external structure survived, and so today’s White House is the same building that was burned

by the British The White House, “White House History,” available at http://www.whitehouse.gov/about/history

b The Democratic-Republican Party splintered in the 1820s; one faction became the modern Democratic Party The Federalist Party dissolved in the 1820s The modern Republican Party was founded in the 1850s.

c A bond is a promise to pay a speci ed amount of money at some point in the future, so selling a bond is a way of borrowing money For example, the Treasury might issue a ten-year,$1,000 bond that pays 5 percent interest: that means that the holder of that bond will receive $50 per year and then $1,000 at the end of ten years If the Treasury sells that bond

to an investor for $1,000, then the Treasury is borrowing $1,000 from the investor and the investor is lending $1,000 to the Treasury, at an interest rate of 5 percent.

d Unless otherwise noted, the term “national debt” refers to debt owed by the federal government and held by parties other than the federal government; it does not include obligations of one part of the federal government to another, nor does it include debt owed by state and local governments.

IMMORTAL CREDIT

[The treasury secretary] ardently wishes to see it incorporated, as afundamental maxim in the system of public credit of the United States,that the creation of debt should always be accompanied with the means

of extinguishment

—Treasury Secretary Alexander Hamilton, January 17901

On April 30, 1789, when George Washington was inaugurated as the rstpresident of the United States, the country he would lead was a scal basketcase Less than six years after the Treaty of Paris ended the AmericanRevolutionary War, the new nation was deeply in debt and already in default.The United States had missed interest payments owed to France for severalyears in succession, as well as principal payments due in 1787 and 1788.2 Thecountry’s credit was so poor in the 1780s that some claims on the centralgovernment could be bought for less than 15 cents on the dollar.3 In 1790,when Alexander Hamilton, Washington’s first treasury secretary, added up thenation’s debts, the federal government owed $54 million, almost $12 million

to foreigners; on top of that, he estimated individual states had debts thatadded up to $25 million.4 To put this in perspective, from 1784 to 1789, theContinental Congress was able to bring in only $4.6 million—and half of thatwas borrowed money.5

These debts were the price of ghting the Revolutionary War—the “price ofliberty,” in Hamilton’s words.6 In 1776, the North American coloniesproclaimed their independence from Great Britain, then one of the mostpowerful countries in the world For the next ve years, lacking both theauthority to collect taxes and the good credit necessary to borrow money, theContinental Congress struggled to keep an army of 10,000 men in the eld.The British, by contrast, routinely had 15,000 to 25,000 experienced front-line troops available for battle and had numerical superiority in mostconfrontations.7 The British could deploy so many troops because they hadthe nancial resources to mobilize them—or to hire them from otherEuropean states, as was the case for the Hessians defeated in the Battle ofTrenton

General Washington, by contrast, struggled to keep the British at baybecause there was little money available to mobilize, equip, and pay theContinental Army The Continental Congress lacked both the power and theinfrastructure to levy and collect taxes; without the assured prospect of futureincome (or even survival), the new government had trouble borrowingmoney Most central government payments were made with

“continentals”—paper money issued by the government.8 Benjamin Franklinwas initially impressed by this nancing solution: “The whole is a mysteryeven to the politicians, how we have been able to continue a war four yearswithout money, and how we could pay with paper that had no previouslyxed fund appropriated speci cally to redeem it.”9 But as the governmentissued more and more paper money with nothing to back it, the currency fell

in value, leading Washington to complain in October 1779 that “a wagonload of money will scarcely purchase a wagon load of provisions.”10

Insu cient funds meant that American soldiers had to su er with little food,poor shoes, and derisory accommodations during harsh winters; in the winter

of 1777–1778, 2,500 men died at Valley Forge Anger over irregular pay in adepreciating currency would later contribute to the Pennsylvania Mutiny of

1783, which prompted Congress to relocate from Philadelphia to Princeton,New Jersey

The new nation was fortunate, however France, Britain’s traditionalenemy, was willing to loan money to the Continental Congress despite thehigh risk of not being paid back, and the United States was also able toborrow money in Spain and the Netherlands.11 In addition, the Frenchprovided troops and ships that helped tip the military balance, particularly atthe decisive Battle of Yorktown in 1781, which helped convince the Britishthat the war was no longer worth ghting But it was clear that the UnitedStates could not truly be independent unless the world’s powers werepersuaded that the new country could defend itself, which required money.And to raise the money to ght an eighteenth-century war, nothing was morevaluable than good credit This was a lesson that Washington—and Hamilton,his wartime aide12—learned rsthand from the British, the masters of thesubject

WAR, DEBT, AND TAXES

During the eighteenth century, Great Britain and France were locked in a

struggle for political supremacy in Europe At rst glance, everything seemed

to favor France It had twice as many people as Great Britain (19 millionversus 9 million in 1700), an advantage it maintained throughout most of thecentury Its army was several times as large (350,000 troops to 75,000 in1710); even its eet was larger in the late seventeenth century, although theBritish navy would take the lead in the eighteenth century.13 Its overseaspossessions were the equal of Great Britain’s Yet throughout the century,Great Britain was more than France’s match on the world stage: the twopowers fought to a standstill on the Continent, while Great Britain seizedmost of France’s overseas colonies in the Seven Years’ War (known in theAmerican colonies as the French and Indian War)

The reason was not economic superiority In 1700, France’s economy wasthe largest in Europe, nearly twice as big as Great Britain’s.14 The reason wasthe British government’s scal superiority: its ability to raise money throughboth taxation and borrowing To begin with, Great Britain had a more

e cient administrative system for collecting taxes in the form of a moderncentralized bureaucracy.15 In France, taxes were collected by “tax farmers”who leased the right to collect taxes, other o cials who bought theirpositions, and various traditional corporate bodies Many of theseintermediaries took their share of tax proceeds before passing them on to thegovernment (and sometimes more than their share).16 Still, no country could

a ord to ght the wars of the eighteenth century solely with tax revenue, and

so the crucial factor was a government’s ability to borrow money Here GreatBritain had two major advantages The rst was its superior ability to raisetaxes, which gave lenders con dence that the loans they advanced duringwartime could be paid back by taxes in peacetime.17 The second, and moreimportant, was that government debts had to be approved by Parliament,which also had the power to raise taxes

Parliamentary control over spending and taxation was a long-termconsequence of the Glorious Revolution of 1688, in which the Catholic KingJames II was deposed in favor of the Protestant King William III and QueenMary II The Revolution led to heightened competition between Whigs(associated with commercial and nancial interests) and Tories (representingtraditional landowners) William III relied on Whig support to ght on theContinent against King Louis XIV of France; the Tories, by contrast, preferred

to withdraw from the Continent and rely on the navy to protect GreatBritain.18 The need for new taxes and borrowing to ght the War of theLeague of Augsburg (1689–1697) and the War of the Spanish Succession

(1702–1713) increased the power of Parliament relative to the monarchy,making scal and economic policy more dependent on public support.19

Parliamentary oversight and the perception that the tax system was basicallyfair were also major reasons why British society was willing to endureunprecedented levels of taxation.20

In the three decades that followed the Glorious Revolution, the Britishgovernment was able to borrow vast sums of money to ght the French, itsnational debt growing from £1 million to £54 million.21 That borrowing wassupported by taxes that tripled between the 1670s and 1715.22 Still, it wasonly the advent of Whig dominance in 1715 that ensured Great Britain’s goodcredit; a large Whig majority—representing the nation’s creditors, amongother groups—provided con dence that the government would continue topay its debts by raising taxes if necessary, allowing it to borrow money atrelatively low interest rates.23 By the time Whig control of Parliament ended

in 1760, the idea that servicing the national debt was a crucial priority hadbecome far less controversial.24 And this was the secret to winning wars in

the eighteenth century As Daniel Defoe (of Robinson Crusoe fame) wrote,

“Credit makes war, and makes peace; raises armies, ts out navies, ghtsbattles, besieges towns; and, in a word, it is more justly called the sinews ofwar than the money itself.”25

France, by contrast, was in a near constant state of nancial crisis.26 TheEstates General (a representative assembly that was France’s closestapproximation to Parliament) had not met since 1614, debts were incurred

by the monarchy, and taxes were based on the monarchy’s traditional rightsand privileges or imposed without consent by the king.27 The haphazard taxcollection system made it di cult to bring in revenues reliably.28 The sale of

o ces—bureaucratic or professional positions, sometimes carrying socialdistinction—was a major source of revenue, but also meant that thegovernment had to pay “interest” in the form of salaries to o ceholders.29

The di culty of raising adequate revenues through taxation meant that warsperiodically led to escalating debts;30 the government often responded bydefaulting or unilaterally rescheduling debt repayments, as occurred in 1715,

1722, 1759, 1763, and 1772.31 Without the assurance of future revenues toback it up, government debt can quickly become worthless paper And unlike

in Great Britain, creditors had little political power and hence no reason totrust the government to make good on its debts.32 As a result, France had topay interest rates that not only were higher than those paid by Britain butalso were higher than those paid by the private sector in France.33

The di erence between the two countries became clear after the AmericanRevolutionary War At rst glance, Great Britain seemed to come out of thewar in worse shape, and not just because it lost Britain had nanced the warentirely by new borrowing, and it ended the war with a larger national debtthan France (and a much smaller population); in 1782, 70 percent of allBritish government expenditures went to interest on the debt.34 (In the UnitedStates today, the corresponding gure is 6 percent.)35 But Britain bene tedfrom lower interest rates, thanks to its good credit, and, more importantly,was able to raise taxes in the 1780s, bringing its debt under control.36 WhileFrance’s debt was smaller than Britain’s, it was unable to raise taxes due tothe weak legitimacy of the monarchy, and so it had to resort to even moreborrowing even after the war ended; by 1789, interest payments wereconsuming 68 percent of all government spending and growing each year.37

Finally, King Louis XVI was forced to call the Estates General, whichconvened on May 5, 1789, leading rapidly to the French Revolution and theoverthrow of the monarchy At the time, e ective tax rates in Britain werenearly twice as high as in France, leading historian Kathryn Norberg toconclude, “More than any other factor, the inability to tax brought down theFrench treasury and with it the absolute monarchy.”38

Even then, some things did not change The Revolution and the rise ofNapoleon Bonaparte led to another twenty years of war, and Great Britaincontinued to enjoy a vast scal advantage, raising more in taxes than France,which helped fund the coalition that would eventually defeat Napoleon.39 Bythis time, the Industrial Revolution was well under way in England, and GreatBritain would be the dominant world power for the next century

What was the main di erence between Great Britain and France? It wasn’tthe size of their national debts: at the time of the French Revolution, GreatBritain’s debt per person was much larger than France’s The di erence waspolitics In Great Britain, the political system was dominated by electedrepresentatives who supported an activist government and were willing toendorse the taxes necessary to pay for its resulting debts In France, thegovernment did not have the legitimacy necessary to raise the money toservice its smaller debts And although its tax rates were lower than Britain’s,the problem of taxation without representation was an important cause ofthe Revolution.40

LAYING THE FOUNDATIONS

Alexander Hamilton’s views on public nance were shaped during theRevolutionary War and largely based on Britain’s successful example.41 Hewas well aware of the connection between good credit and national power:

“ ’Tis by introducing order into our nances—by restoring public credit—not

by gaining battles, that we are nally to gain our object,” he wrote in 1781.42

As treasury secretary, one of his principal goals was ensuring that the UnitedStates would be able to raise money in times of national emergency It was a

“plain and undeniable truth,” he asserted in 1790, “that loans in times ofpublic danger, especially from foreign war, are found an indispensableresource, even to the wealthiest of [nations].”43 For Hamilton, this meantreshaping American fiscal policy in the British image

When Hamilton took o ce, however, the United States was on course toimitate France, not Great Britain, at least in its scal a airs The country hadmissed required interest payments for years and seemed to have no realisticprospect of paying its debts The national government and the states togetherowed about $79 million—probably about 40 percent of GDP, which wouldnot seem particularly high today.44 But the economy was very di erent then,with much more agriculture and much less industry and trade, and thefederal government lacked a modern apparatus for collecting taxes, making it

di cult to bring in a large amount of revenue.45 At the time, Hamiltonestimated that paying interest in full on the foreign and domestic debt wouldcost more than $4.5 million.46 The United States’ limited ability to nancethe debt raised the prospect of a serious and persistent debt crisis

These dangerous scal straits had been one motivation for theConstitutional Convention of 1787, which created the executive branch ofgovernment that Washington and Hamilton now inhabited Under the priorArticles of Confederation, the central government could spend money but had

no power to levy taxes, instead relying on contributions from the states,which often refused to comply.47 In 1779, John Jay, then president of theContinental Congress, exhorted the states to contribute to the war e ort:

“Recollect that it is the price of the liberty, the peace and the safety ofyourselves and posterity, that now is required.”48 But without an independentexecutive or judicial branch, the central government had no enforcementpowers over the states and could not compel contributions As superintendent

of nance in the early 1780s, Robert Morris tried to raise money for thecentral government, even using his own personal credit, but was often unable

to obtain the necessary cooperation of the individual states.49 As Davis Rich

Dewey wrote in his Financial History of the United States, “Morris after all had

little real power; he could not overcome the fundamental obstacles in theway of healthy nance; State pride, jealousy, and bickering withstood hisappeals to the States to levy taxes.”50

The lack of a reliable source of revenues was one reason for the centralgovernment’s persistent weakness As Sidney Homer and Richard Sylla put it,

In spite of the great potential economic strength of the new country, itsnancial and political system broke down completely in 1786 Credit athome and abroad was no longer available The impossibility ofgovernment without money, credit, or power led to the ConstitutionalConvention of 1787 and a new nation in 1789.51

The convention responded by giving the new Congress power “To lay andcollect Taxes, Duties, Imposts and Excises, to pay the Debts and provide forthe common Defence and general Welfare,” as well as “To borrow Money onthe credit of the United States.”52 Still, however, many politicians—whogenerally had only a local power base—feared a strong central governmentwith too much power to borrow money, increase spending, and expand its

in uence over everyday life For the new constitution to command popularlegitimacy, it had to reconcile multiple con icting interests and balance thedominant political forces of the time.53 As a result, the Constitution itself isunclear on how far the federal government’s authority reaches Congress hasthe power “To make all Laws which shall be necessary and proper forcarrying into Execution the foregoing Powers”54—language that wouldprompt extensive debate over what the government can actually do

The power of the federal government was the central issue during PresidentWashington’s rst term in o ce, with his two top o cials on opposing sides

of the debate Thomas Je erson, then secretary of state, argued for a narrow

de nition of the government’s powers, particularly in the realm of scalpolicy,55 while Treasury Secretary Hamilton asserted that Congress could passlegislation that enabled the government to further the purposes authorized bythe Constitution In 1787–1788, Hamilton had collaborated with JamesMadison and John Jay on the Federalist Papers, a series of articles arguing forrati cation of the Constitution and thus the creation of a relatively strongcentral government; Je erson was U.S ambassador to France at the time butwas kept informed during the rati cation debates by his ally Madison.56

During the rst years of the new administration, however, both Je erson andMadison (then a member of the House of Representatives) increasingly

opposed Hamilton, who they thought was excessively enamored of strongcentral government This split would soon lead to the partisan divide betweenHamilton’s Federalists and Je erson and Madison’s Democratic-Republicans(or Republicans).

Taxes, spending, and the national debt were at the center of this debate.For Hamilton, prosperity and independence required a strong centralgovernment that could mobilize resources quickly in order to cope withnational emergencies— rst among them war Rapid access to cash depended

on the con dence of the credit market.57 Sound economic management andpolitical stability were based on and measured by the ability to issue debt atreasonable interest rates But to borrow money, a government had to havethe ability to nance its debts, which required a well-de ned revenue stream

In his 1790 “Report on Public Credit,” Hamilton concluded,

Persuaded, as the Secretary is, that the proper funding of the present debtwill render it a national blessing, yet he is so far from acceding to theposition in the latitude in which it is sometimes laid down, that “publicdebts are public bene ts”—a position inviting to prodigality, and liable

to dangerous abuse—that he ardently wishes to see it incorporated, as afundamental maxim in the system of public credit of the United States,that the creation of debt should always be accompanied with the means

of extinguishment This he regards as the true secret for rendering publiccredit immortal.58

In order to be able to borrow money when necessary, the government wouldhave to prove that it could pay it back.59

The nation’s huge debts presented the opportunity to put these principlesinto action Not only did Hamilton want to restructure the federalgovernment’s obligations, but he also wanted the government to assume thedebts incurred by the states and pay interest on them as well Since thegovernment did not have enough cash on hand to do so—it had alreadymissed both principal and interest payments—he proposed to buy back theoutstanding debt with new Treasury bonds The planned debt swap wascarefully calibrated Hamilton proposed multiple classes of bonds, withinterest rates ranging from 3 percent to 6 percent All could be redeemed atthe government’s option, but there were limits on how much the governmentcould buy back each year.a Holders of debt issued by the ContinentalCongress or of “state debts incurred for national purposes” could exchange

their old debt for new Treasury bonds.60 This voluntary restructuring(creditors did not have to participate) appealed to the debt holders’ self-interest If the plan succeeded, the government would soon be able to redeemany old debts that were not converted, which meant they would no longerpay interest Therefore, investors who wanted long-term streams of interestwere better o converting their bonds.61 Of course, issuing new bondsrequired a way to pay the interest on those bonds To that end, Hamiltonplanned to supplement existing tari s with new excise taxes on liquor, tea,and co ee.62 He later also proposed to charter a new Bank of the UnitedStates, which, while privately owned, would provide liquidity to the bondmarket and help the government borrow money rapidly in a crisis.

While Hamilton saw the national debt as either a necessary evil orsomething that was good in itself, Je erson and Madison were rmlyopposed to debt.63 For them, borrowing and the taxes it necessitated providedthe cash that enabled governments to centralize power and to ght wars—both of which were bad In 1795, Madison wrote,

Of all the enemies to public liberty, war is perhaps the most to be

dreaded, because it comprises and developes [sic] the germ of every

other War is the parent of armies; from these proceed debts and taxes;and armies, and debts, and taxes are the known instruments for bringingthe many under the domination of the few.64

Je erson and Madison feared that Hamilton’s plan, by creating themachinery to issue debt and collect taxes, would give too much power to thefederal government and set the precedent for further borrowing andpermanent indebtedness They particularly objected to the idea of paying o

current debt holders in full since in some cases speculators had bought debt

certi cates cheaply from veterans of the Revolutionary War Madisonproposed several alternatives that would have been less favorable to currentcreditors In one proposal, the value of each debt certi cate would dependnot just on its face value but also on its own idiosyncratic history But as

Madison himself later acknowledged, “the proposition for compromizing [sic]

the matter between original su erers and the stockjobbers, after being longagitated, was rejected by a considerable majority, less perhaps from a denial

of the justice of the measure, than a supposition of its impracticality.”65

In Congress, Madison drew the line at federal assumption of state debt Heargued that by essentially bailing out states that were behind on their debt

payments, it penalized those—like Virginia, his home state—that had alreadypaid o most of their Revolutionary War debts.66 By June 1790, the House ofRepresentatives had approved most of Hamilton’s scal plan, except forassumption of state debt, thanks to Madison’s e orts At the same time, therewas an ongoing debate over where the nation’s capital city should be located.Finally, Hamilton, Je erson, and Madison reached a compromise—according

to Je erson, over a private dinner at his house on June 20 Hamilton agreed

to push for the banks of the Potomac River as the site of the future capital(and to support a favorable debt settlement for Virginia), while Madisonagreed to nd enough votes to back the assumption plan, which nallypassed on July 26.67 Madison and Je erson later opposed the creation of theBank of the United States, but Hamilton won that battle in Congress and thenconvinced President Washington not to veto it.68

In the end, Hamilton’s plan was an economic success Because the debtswap was attractive to creditors, he was able to restructure the outstandingdebt at reasonable interest rates.69 The new taxes helped bring the budgetroughly into balance, making the U.S government a more attractive creditrisk In 1787, the yield on government debt was in the range of 26–40percent; investors could buy interest-bearing claims on the government for 15percent of their face value, a huge discount.b By 1791, the yield ongovernment debt had fallen below 9 percent; while the early data have biggaps, interest rates seem to have remained around 8 percent for the rest ofthe decade.70 The newly issued government bonds became an attractiveinvestment in European credit markets, helping attract capital to the UnitedStates Most importantly, the broader credit system functioned again, helping

to stimulate sustained economic growth.71

Although Hamilton’s scal system was good for the new federalgovernment, there was still a price to be paid—the taxes that he introduced

to service the larger government debt Popular opposition to those taxes,particularly the tax on whiskey, was fueled by general discontent with thenew, more centralized political system ushered in by the Constitution On aneconomic level, taxing farmers who produced grain and distilled it intowhiskey (or the people who drank the whiskey),72 in order to pay o olddebts at their full face value, seemed like a transfer of wealth from ordinaryAmericans to the East Coast elites and speculators who held governmentdebt.73 Farmers on the Western frontier often chose to produce whiskeybecause it was cheaper than grain to transport to market, so the taxthreatened their basic livelihood Both tari s and excise taxes are e ectively

consumption taxes, which tend to be regressive (compared to property orincome taxes), although in early America it could be argued that they appliedprimarily to luxuries.74 On a political level, the whiskey tax demonstrated thedangers posed by a powerful central government that appeared moreconcerned with commercial interests and the investor class than with farmers

in the West and South In this context, the federal structure created by theConstitutional Convention seemed to constitute an abandonment of thepopular democratic principles that had contributed to the AmericanRevolution

Opposition to the whiskey tax and to the federal government slowlycrystallized in the United States’ rst serious tax revolt: the WhiskeyRebellion, which gradually grew from protests against Hamilton’s proposals

in 1790 to armed resistance in 1794, particularly in western Pennsylvania.75

The rebellion brought together economic grievances against the new taxesand political grievances against a government seen as controlled by economicelites.76 But a government that was only ve years old, which needed taxrevenues in order to ensure its scal stability (and perhaps its continuedexistence), saw the rebellion as a test of its determination to enforce thelaw.77 After hesitating—in part out of fear that military action would onlybroaden opposition—President Washington called up a militia and dispatched

it to Pennsylvania to put down the rebellion.78 This show of military forceagainst internal opposition demonstrated that the federal government wasserious about exercising its new powers, at least where money was concerned

In the words of historian Howard Zinn, “We see then, in the rst years of theConstitution, that some of its provisions—even those paraded mostamboyantly (like the First Amendment)—might be treated lightly Others(like the power to tax) would be powerfully enforced.”79

On the one hand, scal policy is about ensuring that the government hasthe resources necessary to address current public priorities and respond tofuture emergencies On the other hand, since it involves the crucial questions

of who pays taxes and who bene ts from government spending, scal policy

is fundamentally about the distribution of income and wealth Hamilton’spolicies were successful at establishing the solvency and creditworthiness ofthe U.S government But the Whiskey Rebellion showed how thedistributional implications of taxes and spending can provoke bitter politicalopposition—something that the United States has seen again and againthroughout its history

ALL TOGETHER NOW

The 1790s were one of the most divisive periods of American politicalhistory, with the Hamilton-Je erson feuds hardening into the split betweenFederalists and Democratic-Republicans, which saw partisan strife that wouldseem excessive even today In 1801, for example, after Federalist presidentJohn Adams had lost the 1800 election to Je erson, Federalist majorities inCongress passed the Judiciary Act—which e ectively allowed Adams and hisparty to pack the federal courts with sympathetic judges The Republicansresponded by repealing the act the next year, tossing the new judges out ofoffice.80

The parties were still far apart on scal issues, with the Republicanspreferring smaller government and lower taxes than the Federalists Je ersonacknowledged the importance of good credit, writing in 1788, “Though I am

an enemy of the system of borrowing, I feel strongly the necessity ofpreserving the power to borrow Without that, we may be overwhelmed byanother nation merely by the force of its power to borrow.”81 Madisonsimilarly had used the need for wartime borrowing as a justi cation forgiving the federal government the power to tax.82 But after taking power in

1801, Je erson and Republican majorities in Congress set out to overturn keycomponents of the Federalist scal program originally designed by Hamilton,preferring to cut taxes and shrink the federal government—which, at thetime, consisted mainly of the army and navy (Unlike in some other countries,however, they did not attempt to renege on debts incurred by the previousgovernment; nor did they attempt to reopen the controversial debates of

1790 over the restructuring of federal and state debt.)83

The man that Je erson and Madison put in charge of the nation’s nanceswas Albert Gallatin, treasury secretary from 1801 to 1814.84 As Gallatinwrote to Je erson in 1809, “The reduction of the debt was certainly theprincipal object in bringing me into o ce.”85 Gallatin was particularlyopposed to maintaining the national debt in-de nitely, arguing that “owing adebt cannot contribute more to the welfare, happiness, and real opulence of apeople than a private debt contributes to the wealth and prosperity of anindividual.”86

Gallatin was born in Switzerland and immigrated to the United States in

1780 at age nineteen In 1790 he was elected to the Pennsylvania GeneralAssembly, where he stood out for his grasp of scal issues A ferventopponent of Hamiltonian “big government,” he was elected to the Senate in

1793 as a Democratic-Republican, but he was almost immediately removedfrom o ce on a technicality by the Federalists.87 Back in Pennsylvania,Gallatin participated in the Whiskey Rebellion, although he arguedconsistently for moderation and against unlawful opposition to thegovernment.88 In 1795 he returned to Congress, this time as a member of theHouse of Representatives, where he became the Republicans’ main publicnance expert Gallatin relentlessly interrogated Federalist treasurysecretaries on budget details and helped strengthen congressional oversight ofthe executive branch, in part through the creation of the House Ways andMeans Committee.89

As treasury secretary, Gallatin’s main objectives were to cut governmentspending and pay o the national debt After taking o ce in 1801, heforecast that revenue the next year would amount to $10.6 million, withmost coming from tari s but $650,000 from the controversial excise taxes

He allocated $7.3 million to debt payments, leaving the rest of thegovernment—including the military—with just over $3 million From thisstarting point, Gallatin aimed to pay o the national debt by 1817;90 at thesame time, he hoped to repeal all excise taxes “to strike at the root of the eviland arrest the danger of encroaching taxes, encroaching government,temptations to o ensive wars, etc.”91 In 1802, the Republicans repealed theexcise taxes while o setting the tax cuts by reducing spending on the armyand navy—scaling back the navy’s building program and increasing thefederal government’s reliance on state militias.92 Lower spending enabled theTreasury to pay down the national debt: from 1801 to 1812, indebtedness fell

by $38 million (despite a large increase to nance the Louisiana Purchase),leaving $45 million outstanding.93

Over time, however, both Je erson and Madison came to appreciate thepotential usefulness of debt Despite his opposition to debt, Jefferson could be

a pragmatist, borrowing more than $11 million for the Louisiana Purchase.94

In this case, issuing debt had obvious bene ts: doubling the size of the UnitedStates The War of 1812 showed that borrowing—and the taxes to support it

—could also be crucial to national security

During the Napoleonic Wars at the beginning of the nineteenth century,France and Great Britain each attempted to cut o trade with the othercountry Although the United States remained neutral, both countries seizedAmerican merchant ships, with the British sometimes forcing their crews intomilitary service After an adroit move by Napoleon and some belligerentdiplomacy by the British, the United States ended up in a confrontation with

Great Britain over its policy of excluding American shipping from Frenchports.95 Relationships between the two countries were further strained byBritish support for Native Americans against American settlers in the Westand by other resentments left over from the Revolutionary War.

Je erson’s rather dubious response was the Embargo Act of 1807, a imposed trade embargo that hurt the American economy more than that ofGreat Britain In 1809 this was replaced with the Non-Intercourse Act, whichallowed trade with countries other than Great Britain and France Both actswere di cult to enforce, but by pushing trade out of o cial view, theydirectly undermined the main source of Treasury revenues—tari s As early

self-as 1807, recognizing the possibility of military con ict, Gallatinrecommended that any war be funded through loans, but also that taxesshould be su cient to pay the interest on that new debt But in 1811 and

1812 Republican War Hawks—including Henry Clay, then speaker of theHouse of Representatives, and John Calhoun, who would later become vicepresident—resisted Gallatin’s proposals for new excise taxes.96 In Davis RichDewey’s words, “In spite, then, of needs which were early apparent, Congressdeterminedly and de nitely turned away from a policy of adequatetaxation.”97 In 1811, Congress also voted not to renew the charter of the Bank

of the United States, against the wishes of Gallatin and Madison (who hadbecome a supporter of the Bank), leaving the government without acentralized channel for distributing loans shortly before it went to war.98

Frustration with what appeared to be repeated British infringements onAmerican sovereignty, both in the Atlantic and on the Western frontier,nally led to a declaration of war in 1812, even though both the military andthe Treasury Department were unprepared for the con ict.99 Totalgovernment spending quadrupled from 1811 to 1814, yet revenues—asalways, highly dependent on external trade—remained essentially at.100 Thisgap could only be closed by borrowing, but there was relatively little appetite

to invest in a country at war with the world’s richest country and mostpowerful navy Many industrial and commercial leaders in the relativelyprosperous Northeast were lukewarm about war with their most importanttrading partner.101 The refusal of Congress to authorize new taxes also made

it di cult for the Treasury Department to raise new money, especially aftertwo invasions of Canada ended in failure and with the British blockadingAmerican ports.102

In 1813, it was di culty nding lenders that forced Gallatin to turn toStephen Girard for help raising money103 and nally convinced Congress to

reintroduce some of the same internal taxes that the Republicans hadeliminated in 1802 The following year, at the urging of Treasury SecretaryAlexander Dallas, Congress raised taxes again.104 Even with these measures,however, the United States had trouble making ends meet By the end of

1814, the military supply system was breaking down because of a shortage ofcash, and Dallas warned that spending in 1815 would be more than threetimes as high as revenues.105

Thanks to some money and to increasing experience, American militaryfortunes did stabilize beginning in 1813, although another invasion ofCanada failed later that year After the fall of Napoleon in early 1814,however, the British were able to send larger, more experienced armies acrossthe Atlantic In August, it was veterans of the European wars who sailed upChesapeake Bay, overwhelmed Washington’s meager defenses, and burned theWhite House.106 Fortunately for the Americans, the whole campaign wasmeant primarily as a diversion, and the British soon withdrew.107

Although the United States survived the War of 1812, the accompanyingscal crisis proved the importance of government borrowing and of theinfrastructure necessary to raise large sums quickly By the end of the war,the national debt stood at more than $120 million, a record in nominal termsbut probably only about 15 percent of GDP.108 But, as Hamilton had realized,some amount of debt could be consistent with both political stability andeconomic prosperity A given debt level is “sustainable” if lenders think thatthe government will be able to make required principal and interest payments

in the future In this context, it is the scale of the debt relative to the size ofthe economy that matters, because a larger economy means a bigger tax basefrom which government revenues can be drawn If the economy grows fasterthan the debt increases—because growth is high, interest rates are low, or thebudget is in surplus—then lenders will have con dence in the government’sability to pay and will buy bonds when it needs to borrow

Maintaining that con dence is crucial to preserving the government’sability to borrow money in a crisis, of which war is the classic example.Con dence in government debt can also provide economic bene ts Bothfamilies and companies want to park their savings in a risk-free, interest-bearing asset, of which government debt—at least that issued by certaincountries, such as the United States—is the best example A liquid market forgovernment bonds can also bene t the nancial system by providing a risk-free instrument to use as collateral for nancial transactions The ability toissue debt, however, depends on more than just having a large and sound

economy Lenders will believe they are likely to be repaid only if thegovernment has the ability to generate revenues from that economy Thepublic nance system ultimately rests on the ability to levy and collect

su cient taxes to service the debt This was a crucial lesson of the War of

1812 As Treasury Secretary Dallas said near the end of the war, thegovernment’s fundamental problem was the “inadequacy of our system oftaxation to form a foundation of public credit, and the absence from oursystem of the means which are the best adapted to anticipate, collect, anddistribute the public revenue.”109

The ideas that a government should always pay its debts and that goodcredit is crucial to national power may seem uncontroversial But oneperson’s interest payments are another person’s taxes, so making thosepayments requires the political will and the popular legitimacy to raise andcollect taxes This was the fundamental source of Great Britain’s power in theeighteenth century (until the Industrial Revolution made it also Europe’seconomic powerhouse), and Hamilton consciously attempted to mold theUnited States in the British model Je erson, Madison, and Gallatin alsobelieved that debts should be paid, but it was not until the War of 1812 thattheir party became reconciled to the need for new taxes to nance emergencyborrowing And after the war, in 1816, a Republican Congress chartered theSecond Bank of the United States, following the blueprint drawn byHamilton

Fiscal prudence and restrained government were certainly part of theAmerican system of public nance established in the late eighteenth andearly nineteenth centuries By today’s standards, even Hamilton wouldprobably qualify as a scal conservative; the idea that the budget shouldordinarily be balanced (barring a national emergency, of which war was theonly known example) was virtually unquestioned.110 (State governments, bycontrast, often over-borrowed and occasionally defaulted in the earlynineteenth century; over time, they have generally imposed constraints onthemselves to prevent taking on too much debt.)111 But the ability to raisetaxes when necessary to service and pay down the debt—and, eventually, thegovernment’s consistent track record at doing so—was what made it possible

to maintain the country’s good credit even amid adversity When it came topublic nance, the United States successfully emulated the model of GreatBritain, not that of pre-Revolutionary France

Figure 1-1: National Debt as a Percentage of GDP, 1790–1945

Because the United States did not face another major war until the 1860sand the federal government played a relatively minor role in economicdevelopment, there was no pressing need to borrow large amounts of money.After the War of 1812, high tari s (imposed in part to protect domesticindustry), increased international trade, and dedicated tax revenues made itpossible to reduce the national debt to virtually nothing in the mid-1830sunder President Andrew Jackson, an enemy of debt in any form Withgovernment spending low, the national debt uctuated below 3 percent ofGDP until 1861 (see Figure 1-1) The issue that had so sharply dividedFederalists and Democratic-Republicans in the 1790s slowly faded from thepolitical scene

STRESS TEST

After decades of seeming irrelevance, the importance of a large credit linebecame strikingly clear with the onset of the Civil War in 1861 As the rstmajor con ict between industrialized societies, the four-year struggle was byfar the most expensive war in American history to that point Federal (Union)government spending rose to levels twenty times as high as in peacetime,taking up 25 percent of the national economy by the end of the war.112 TheUnion had many advantages, including double the population and an even

larger edge in industrial production—including 32 times the capacity forproducing rearms.113 The Confederacy was also at a nancial disadvantage,with 30 percent of the nation’s assets but only 12 percent of the circulatingcurrency and 21 percent of the banking assets.114

A bigger problem for the South, however, was that it lacked both theinfrastructure to collect taxes and the credibility to borrow money.115 TheRichmond government was forced to print paper money to pay most of itsexpenses, including military spending In moderation, printing money can be

a reasonable strategy, particularly if in ation pressures are low But usingpaper money to nance large amounts of spending—especially if the publichas no reason to believe the government will ever stop printing money—islikely to cause in ation as people come to expect the printing presses to runforever Because there was little reason to believe the Confederacy could everbreak its dependence on paper money, printing money triggered a wave ofhyperinflation.116 Prices rose on average by 10 percent per month and, by theend of the war, the price level in the South was 92 times its starting level—adegree of in ation that wreaks havoc with the ordinary functioning of anyeconomy.117

The North, by contrast, could increase taxes and issue debt—although even

so it struggled to raise enough money to meet the war’s unprecedented costs.Salmon P Chase, President Abraham Lincoln’s treasury secretary, recognizedthe need for new revenues early in the war Anticipating total spending of

$320 million in the 1862 scal year (July 1861 through June 1862)—almosteight times total revenues in 1861—he asked for taxes that would cover theinterest on wartime borrowing and create a fund to eventually repay thatdebt The government increased taxes repeatedly, even levying the rstincome tax in American history (at a rate of 3 percent on income over $800per year), eventually collecting over $300 million in 1865 But taxes paid foronly about one-fourth of the war’s costs.118

The solution was borrowing on an unprecedented scale For the rst time,the government tapped into the savings of ordinary Americans Jay Cookebecame perhaps the rst famous investment banker in American history byselling government bonds, in denominations as low as $50, using thousands

of subagents and newspaper advertising—the mass media of the time.Through these “bond drives,” Cooke successfully sold bonds to about 5percent of Northern households—in the process vastly expanding the number

of people with a direct stake in the national debt.119 By 1863, the Union wasable to close most of its budget gap by selling these long-term bonds.120 The

result was an enormous increase in the national debt, from $65 million in

1860 to almost $2.7 billion (almost 30 percent of GDP) in 1865.121

Government bond prices reached their lowest point in 1861, when the yield

on long-term government debt climbed as high as 6.98 percent—but this wasstill below the peak yield during the War of 1812.122

Despite its superior ability to collect taxes and sell bonds, the Union stillfaced its share of scal emergencies Early in the war, the TreasuryDepartment was unable to sell bonds fast enough to meet the military’sfunding needs, forcing Congress to authorize paper currency—the rst

“greenbacks”—to keep the federal government in operation and pay thetroops in the eld.123 As in the South, paper money lost value quickly; while

$100 of greenbacks could be bought for $98 in gold in January 1862, by July

1864 they cost only $39 in gold.124 Relying on printing presses to pay the billscaused high in ation; unlike in the South, however, prices in the North “only”doubled during the course of the war, limiting the damage to the economy.125

While the Civil War stretched the Union government’s capacity to raisemoney through taxes and borrowing, it did not break, enabling the North tokeep its armies in the eld long enough to wear down the South OneConfederate leader supposedly went so far as to say, “The Yankees did notwhip us in the field We were whipped in the Treasury Department.”126

Following the Civil War, the government followed the pattern set in the1790s and after the War of 1812: high taxes dedicated to paying down thedebt Those taxes were controversial, as always, but they had strongsupporters in Congress The industrial and manufacturing interests thatdominated the postwar Republican Party wanted high import tari s toprotect themselves from foreign competition The tari s were politicallydivisive because they increased the prices of consumer goods,disproportionately a ecting lower- and middle-income families—especiallythose in the South and West who did not bene t from protectionism But theRepublican majorities that controlled Congress for most of the late nineteenthcentury set tari s signi cantly higher than was required simply to meet thegovernment’s revenue needs, even while eliminating the income tax.127 As aresult, the government ran a consistent budget surplus from the end of thewar through 1893, enabling the national debt to fall to less than 10 percent

of GDP

This was also the period when the United States became one of the world’sforemost economic powers American prosperity was based, rst andforemost, on a strong system of institutions Secure private property rights,

relatively cheap land, and early industrialization attracted millions ofimmigrants (although serious economic problems in Ireland, Italy, and otherparts of Europe also contributed to the ow of people across the Atlantic).

T h e U.S population rose from around 2.5 million people when theRevolutionary War began to more than 23 million in 1850 and 76 million in

1900.128 American entrepreneurs were also at the forefront of technologicalinnovation from the 1840s (if not earlier) and were responsible for the large-scale development of railways and electric power, the application of a myriad

of improvements to agriculture and industry, and key breakthroughs intelecommunications These rapid improvements in productivity, coupled with

a historical surge in human capital, gave the United States the world’s largesteconomy, probably at some point in the 1870s.129

Industrialization and technology also set in motion a long, gradual change

in the role of the government in American society For example, medicaladvances made it practical to think about public health investments Thegerm theory of disease and the discovery of speci c pathogens madeapparent the importance of clean water, which justi ed major expenditures

on reservoirs, ltering equipment, and piped water.130 As vaccines becameavailable, their positive spillover e ects—the more people that arevaccinated, the less likely a disease is to spread—created a rationale forpublic policies to encourage their use The development of modern medicineprovided a basis for regulatory policies to protect the public from fake

“patent medicines.” Similar forces were at work in many other domains ofmodern life: the economic power of the railroads led to their regulation bythe Interstate Commerce Commission beginning in 1887, while increasingurban poverty and the high injury rates of nineteenth-century factories led tostate workers’ compensation laws in the early twentieth century.131 In thedecades following the Civil War, income security—in the form of veterans’pensions—also became a major responsibility of the federal government,accounting for one-third of all spending in 1890.132 Although many newgovernmental responsibilities fell to state and local governments, the federalgovernment broadened its mandate as well For the most part, however,domestic spending remained small relative to the economy (and by today’sstandards),133 and could generally be paid for by the high tari s thatRepublicans favored for economic reasons The scal consequences of thislong-term trend would take decades to become clearly visible

If population and productivity were the main sources of Americaneconomic development, politics and public policy were also important The

early United States had the potential for intense social polarization and evenrepeated armed con ict of the kind seen in many Latin American countriesduring the nineteenth and twentieth centuries Colonies based on Europeansettlement have generally done better over the past two hundred years thanthose in which Europeans made money primarily by controlling anindigenous population.134 When the political business model involvesattracting new people—for example, to settle in the Western United States—political leaders have a strong incentive to treat ordinary people fairly Butsocieties based on European settlement did not necessarily produce popularlegitimacy and prudent scal policies, as evidenced by Argentina, amongother countries Extreme inequality, populist uprisings, and reactionarycrackdowns can all produce political instability and undermine sustainedeconomic growth.135 Endemic political con ict and low levels of legitimacyalso make governments more likely to default on their debts The “originalsin” of nineteenth-century defaults can even today make it hard for someLatin American countries to borrow money in their own currency.136

The United States, however, did not go down that path Ours has neverbeen a perfect democracy—slavery, most obviously, would put the lie to thatclaim But there was enough consensus among political elites to grant enoughrights to enough social groups to ensure that the political system maintained

a basic level of popular legitimacy Governments of di erent political stripesenjoyed the credibility required to borrow when necessary; growth in theeconomy and especially in international trade made it possible to collect thetaxes necessary to nance that debt It is a simple formula, but one that fewcountries mastered

PAYING FOR TOTAL WAR

The United States’ ability to borrow money in a national emergency wasnever more on display than during the world wars of the rst half of thetwentieth century During World War I, federal government spendingincreased more than twenty-fold, from $700 million in the 1916 scal year tomore than $18 billion in 1919—more than 20 percent of GDP Unlike theRevolutionary War, the War of 1812, and the Civil War, however, thegovernment was able to meet its funding needs through taxes and borrowingwithout risking a scal crisis Congress raised taxes repeatedly before andduring the war, increasing revenues from less than $800 million in 1916 to

more than $5 billion in 1919.137 The government’s ability to collect revenueshad been strengthened by the Sixteenth Amendment, which in 1913unequivocally gave Congress the power to levy an income tax.c There wasconsiderable controversy over which taxes should be raised The largest share

of new revenues come from corporate taxes and individual income taxes,giving the government a reliable source of revenues that did not depend onthe volume of international trade.138 As usual, the Treasury had to borrowmoney to ll the gap between spending and tax revenues, but this time itscredit remained strong throughout the war, enabling it to sell all of the bondsauthorized by Congress—with the assistance of the Federal Reserve, thecountry’s new central bank, which had been created only in 1913 Thenational debt grew from $1.2 billion in 1916 to more than $25 billion in

1919, about 30 percent of GDP, but interest rates remained low and in ationwas lower than in previous wars.139

After the war, in keeping with past practice, the government ran surplusesfor the entire decade of the 1920s in an e ort to bring down the nationaldebt Conservative Republicans wanted to roll back the income tax, but werewilling to put balanced budgets and debt reduction rst.140 Even Democraticpresident Franklin D Roosevelt spoke out in favor of a balanced budget.Criticizing the de cit that appeared at the end of President Herbert Hoover’sadministration, he said, “It has contributed to the recent collapse of ourbanking structure It has accentuated the stagnation of the economic life ofour people It has added to the ranks of the unemployed.”141 In his rstbudget, Roosevelt cut the pay of government workers by 15 percent and alsoreduced veterans’ pensions.142

World War II, however, would require the largest budget de cits inAmerican history The war demanded centralized activity on anunprecedented scale In 1938, with war on the horizon, President Rooseveltbegan spending on rearmament; in 1940, he introduced military conscriptionand asked Congress for the money to build 60,000 planes each year But theUnited States military was still underprepared when the Japanese attackedPearl Harbor on December 7, 1941.143 Defense spending rose from less than

$2 billion in 1940 to more than $80 billion by 1945.144 The ManhattanProject alone required a secret $1.6 billion appropriation in 1944.145 TheUnited States also built much of the weaponry used by its allies—and loanedthem the money to pay for it.146

Federal government spending, which had already been growing during theGreat Depression, soared from $9 billion in 1940 to more than $90 billion in

1944 (more than 40 percent of GDP) as the country shifted virtually its entireeconomy to war production Tax revenues rose from less than $7 billion in

1940 to more than $40 billion by 1944 (more than 20 percent of GDP),largely because of major expansions in the individual income tax, which forthe rst time covered a majority of the workforce, and corporate taxes.147

Individual income taxes, which provided less than 20 percent of governmentrevenues in the 1930s, grew to 45 percent in 1944; they have remained above

39 percent ever since.148 As a share of the economy, both spending andrevenues in 1944 set records that still stand today Despite these major andpolitically divisive tax increases, as in previous wars, a majority ofgovernment spending was paid for by new borrowing, this time on anenormous scale; the 1943 budget deficit of $55 billion exceeded 30 percent of

GDP—more than the government had ever spent in any one year before.149 As

in World War I, the Treasury Department’s fundraising e orts were generallysuccessful: a series of bond drives brought in more than $150 billion atrelatively low interest rates, even as the national debt grew to exceed 100percent of GDP—three times as high as the peaks following the RevolutionaryWar, the Civil War, and World War I.150 World War II was fought and won bymillions of troops from dozens of countries, backed by the world’s largesteconomy, but it was paid for by the credit line that Hamilton had set up inthe 1790s

By the end of the war, however, the forces that would transform Americanscal policy over the rest of the twentieth century were already in motion.Although Franklin D Roosevelt stuck with a relatively traditional view ofbudgetary policy, the Great Depression and the New Deal had changed therelationship between the federal government and the population, mostnotably with the creation of Social Security The Depression had also seen thecreation of a new approach to economic policy, pioneered by John MaynardKeynes, which would make later politicians much more sanguine about

de cit spending, even during peacetime Finally, the end of the war saw theneed for a new international economic and monetary system—one in whichthe United States, as the dominant superpower of the capitalist world, wouldnecessarily play a central role

a Investors generally do not like bonds that can be redeemed by the issuer at any time, because then they might be stuck with cash and no good place to invest it.

b Bonds typically have a face value and pay interest as a xed percentage of that face value When investors begin to worry

about whether the issuer can make good on the payments, the market price of the bond falls below face value As the bond’s price falls, its yield—the effective interest rate as a percentage of the price—goes up.

c In the late nineteenth century, increasing inequality created popular pressure for an income tax, and the Wilson-Gorman

Tari Act of 1894 included such a tax In Pollock v Farmers’ Loan & Trust Co (1895), however, the Supreme Court held that the speci c income tax provisions of the Wilson-Gorman Act were unconstitutional Dennis S Ippolito, Why Budgets

Matter: Budget Policy and American Politics (Pennsylvania State University Press, 2003), p 87 It was not clear whether

another income tax might be constitutional until the issue was settled by the Sixteenth Amendment.